Can the Corporate Tax Mess Be Fixed?

American companies boast a strong record of product creation and marketing, but innovation doesn't stop there. They have been innovative in their financial back offices as well, devising ever new ways to avoid paying taxes on their profits.

There is general agreement that the U.S. tax code has become such a thicket of brambles that it should be torn out by its roots. There is also general agreement that so many corporate interests will fight to preserve their particular tax loopholes that wholesale reform from a Congress reliant on campaign contributions from those same corporations is wishful thinking. The question is whether anything can be accomplished toward what ought to be done.

The tax code — corporate or individual — hasn’t been overhauled in a quarter of a century and has become overgrown with loopholes, exceptions, subsidies and other means of tax avoidance that result in corporations, even those in the same industry, paying wildly different rates. The tax code, in a word, is a shambles.

Nominally, the rate for larger businesses is 35%, second only to Japan’s as the highest in the world, and therefore hurting the competitiveness and growth of U.S. companies, so goes the argument. There is a widespread consensus that to make U.S. companies more competitive the 35% tax rate should be cut, but only in return for eliminating the loopholes. But to bring into the Treasury’s coffers at least the same revenue as the present tax scheme means that all tax breaks must be eliminated, according to Congress’s nonpartisan Joint Committee on Taxation. Not just the President’s oft-cited subsidies for oil and gas exploration and corporate jets — they don’t come close to making up revenue lost by a rate cut — but creditable tax breaks such as accelerated write-offs of equipment purchases intended to spur investment and job creation. They would have to be jettisoned as well.

The fact is that, on average, U.S. corporations do not pay anything near the 35%. A recent report from the Government Accountability Office says that loopholes and exceptions result in the largest (profitable) U.S. companies — those with assets greater than $10 million — paying federal income taxes of only 13% of their pretax worldwide income as reported in their financial statements. The addition of foreign, state and local income taxes boosts their effective tax rates by only a point, to 17%. This cuts in half the 26% the media has estimated in the past, the difference being that the GAO has access to actual tax returns.

That average tax rate masks the inequities in the system, though. Companies whose business is solely in the U.S. — food chains, retailers, railroads, truckers, etc. — are exposed to the full 35% (more, counting state and local taxes), whereas companies with extensive foreign operations or transferrable intellectual property such as pharmaceutical patents and software can employ a wealth of tactics to evade U.S. taxes.

The U.S. taxes profits earned by corporations in other countries, but the tax is deferred until the companies bring the cash home — if they ever do. (If they do, taxes paid to other countries are credited against U.S. taxes due). This has acted as an incentive for our large multinationals to transfer activity overseas so as to delay paying the tax.

Perhaps the public’s first awareness of U.S. corporations going to extremes to defer taxes was a New York Times exposé of General Electric in 2011 and the army of 975 tax experts on its payroll who made sure the company paid no U.S. taxes at all on worldwide profits of $14.2 billion in 2010. (Meanwhile, retailer Wal-Mart was saddled with a 33.6% tax bill.)

Just recently there was another flurry of outcry when the public learned how Apple minimizes U.S. taxes. The U.S. taxes corporations based on where they are incorporated, Ireland on where the company is managed. Apple is managed in Cupertino, California, so the company saw that by parking ownership of U.S.-created software and related assets in a tax-free Ireland corporation, and have that transplant company collect steep royalties from all branches on the Apple tree worldwide, it could shift to Ireland the $30 billion in profits it earned between 2009 and 2012 and pay no tax.

Google’s circumventions are even more convoluted, as exposed by Bloomberg Business Week. Payments for advertising sold in Europe, Africa and the Middle East that flow into Ireland are forwarded to no-tax Bermuda, but only after passing through the Netherlands, because Ireland taxes direct transfers to Bermuda, but not to European Union countries. It is worth noting that Google, this quintessential American technology triumph that grew partly out of publically funded research by the National Science Foundation at Stanford University, nevertheless finds it appropriate to go to such extremes to avoid paying taxes to the U.S.

Another beneficiary which believes it owes as little as possible to its birth country is Facebook, which has its foreign headquarters in Ireland and reportedly has set up the same artifice. They join other multinationals that game the system to reduce taxes at home by inflating overseas profits with transfer payments and accounting maneuvers — behemoths such as Pfizer and I.B.M. — which incorporate mailbox companies in the Cayman Islands and elsewhere in which to park overseas profits.

Carl Levin. chair of the Senate Permanent Subcommittee on Investigations, said, “A recent study found that 30 of the largest US multinationals, with more than $160 billion in profits, paid nothing in federal income taxes over a recent three year period”.

The goal of these companies is to achieve “double non-taxation”: booking revenues in countries that impose no taxes and loading up expenses at home to eliminate taxable profits there.

One problem is ethical: How do we justify to struggling businesses in the U.S. why they should pay full rate when so many of the largest corporations pay so much less? The other is practical: Allowing corporations to hold profits abroad tax free encourages them to invest abroad rather than in the U.S. and starves the U.S. Treasury. American companies are holding as estimated $1.6 trillion offshore, funds that they are unwilling to repatriate unless offered a tax break.

The result is that, even though recent years have seen corporate profits at record levels, their contribution to the federal treasury is at record lows. The growing use of tax havens, transfer pricing and other dodges is certainly a factor. Corporations now account for only 9% of government revenues, whereas in 1950 their taxes amounted to 30%. Corporations paid $242 billion in 2012; individual taxpayers were made to cough up $1.1 trillion — $1.9 trillion when payroll taxes are added.

One argument is that taxes on overseas profits should not be deferred, that a company’s entire profit worldwide should be taxed as it is earned, and that deferral gives companies an incentive to move jobs overseas and use accounting legerdemain to shift profits there. Immediate worldwide tax recovery is usually what those on the left propose to maximize government funding. But that does not consider how it might inspire U.S. multinationals to move elsewhere altogether.

The counter-argument is that the U.S. has no justification for taxing that portion of a business’s profits that are generated entirely in another country. The U.S. is virtually alone in the world in doing so. Shouldn’t we adopt a “territorial” tax scheme whereby profits earned in other countries not be taxed at all?

Or, rather than profits earned in a particular country, given how their distribution is manipulated, why not adopt what is called “unitary” taxation. Under that arrangement, irrespective of where corporate tax departments have shifted them, a corporation’s worldwide profits would be apportioned to countries based on a formula based on assets, sales and other activity in each jurisdiction.

But it is hard to imagine the United States acceding to a plan that would give up tax receipts from foreign profits, however rarely the money shows up on these shores.

A middle ground proposal — one that has the Obama administration’s backing — would set a minimum tax on foreign profits at 15%. If the IRS were to find that a company is paying less than 15% on its profits in any other country, it would demand payment of the difference.

Some on the far right, former presidential candidate Ron Paul being the exemplar, would get rid of corporate taxes altogether, and others argue for a national sales tax or the value added tax scheme in force throughout the European Union. Elimination of taxes on corporations would have a much greater effect than the government losing that 9% of its revenue. Taxes collected from individuals would drop as well. That’s because Subchapter S and LLC corporations allow business profits to be passed through to their owners, where they are taxed on their personal form 1040s at rates less than the standard corporation’s 35%. This tax advantage has led to 4.5 million corporations opting to go the “Sub S” route — twice the number of standalone “C” corporations. Dropping the rate for C corporations to 0% would likely cause a stampede back to that form, and a fall off in pass-through business profits now embedded in personal tax filings, causing the federal deficit to balloon.

But proponents of a 0% corporate tax say that businesses from the world over would be drawn to relocate here, creating millions of taxpaying jobs and ending the unemployment problem. Nevertheless, 0%

seems too great a giveaway with these speculative rewards only gradually taking effect. Why not make corporations earn lower tax rates? By qualifying against criteria that match U.S. policy objectives, a company could earn a succession of tax rate deductions — perhaps all the way to 0%, if the idea is taken that far. For example, for each benchmark that a company meets in a list such as the following, that company’s tax rate would ratchet down a notch:

»Number of fulltime jobs in the U.S. relative to the corporation’s size.
»Export sales exceeding a threshold percentage.
»Full compensation of highest paid executive not to exceed X times that of    lowest paid employee.
etc.

Those enticements might serve well enough to lure foreign companies to relocate here.

Tax avoidance has become a major theme for governments at the G8 and G20 economic conferences. Worldwide collaboration on a structure that wipes out tax avoidance schemes, taxes reasonably and apportions fairly would put be of great benefit to all.

Jeffery Kadet, a former tax partner with Arthur Andersen, and now at the Washington University School of Law, describes what such a structure could look like in what he calls a “worldwide full-inclusion” system, the opposite of the “territorial” scheme.

Each country would be free to set its own corporate tax rates, but its taxes would apply to all profits earned by home-based companies no matter where earned and with no deferrals. Taxes charged to those companies by other countries would be deducted from what is owed at home (or the difference credited when other countries charge a rate in excess of the home country’s). With 100% of a company’s profits taxed somewhere, all the avoidance schemes collapse.

True, some companies would be tempted to re-domicile in outlier countries that refuse to join and charge no, or minimal, taxes. That would be rare, however. How many companies would, like Halliburton, want to pick up and move to Dubai, or would find the upheaval of replacing or trying to transfer thousands of employees worth it? Still, member countries in the tax union would need to devise rules that harm uncooperative countries. And because they tax all profits worldwide, home countries would find room to reduce their tax rates to make a company’s staying at home that much more attractive.

Getting all major countries to agree would be difficult, starting with the U.S., where such a proposal would certainly prompt paranoia about an encroaching “world order” and surrendering sovereignty.

So instead we see efforts by Senators Carl Levin of Michigan and Kent Conrad of North Dakota to “tighten the rules”. And an editorial at The New York Times echoes that “Tax rules and enforcement must be tightened to ensure that profits attributable to patents, design, marketing and other intangibles developed in the United States are indeed taxed in the United States”. Easily said and it only serves to make taxation still more complicated. It says that, rather than any grand scheme that actually fixes the mess, all we can expect is tinkering.